Three Tips to Create An Index Fund Portfolio

If you want a “fix it and forget it” portfolio, investing in index mutual funds is a great option.

An index fund is a type of mutual fund made with stocks that match the components of a market index, such as the Standard & Poor’s 500 Index. Index funds diversify your portfolio because you hold a broad variety of securities, instead of a large amount with one company. Index funds are also less expensive because instead of hiring a fund manager to select the stocks, you are buying a sample of the securities in the index.

While you may not get an extremely high rate of return from an indexed mutual fund, they usually perform well and won’t put you at a high risk of losing your savings. Consider these three tips from Christine Benz, director of personal finance for Morningstar, on how to create a steady index fund portfolio.

1. Put around 40 percent in a U.S. total market fund and 10 percent in an international fund

Start out by holding the whole market, based on market values, divided in two index mutual funds: one fund of U.S. stocks and one fund of international stocks. By doing so, you are essentially investing in all of the companies out there so that the highs and lows will balance out.

“It’s a great low-cost, low-maintenance way to go,” Benz says.Since the U.S. and the global economy typically move in lockstep together, with the exception of 2008, you’ve got a total market fund that’s steady because it is well diversified.

2. Invest your remaining percentage in bonds

After stocks, you’ll also want to invest in a total bond market index tracker. As with the stock market index funds, a bond market index fund replicates a broad bond market index by owning many securities from public and private sectors. With a total bond market index, Benz says that you’ll miss out on two categories: junk bonds and treasury inflation protected securities. Besides those two, a total bond market index captures a lot of the action in bonds.

“If you have the core equity exposure as well as a total bond market index fund, I would say you are 97 percent of the way there,” Benz says.

After that, she advises reserving enough cash to cover emergency costs so that means saving about 1-2 years’ worth of income. After you’ve put that emergency money aside, you can throw any extra cash at your investments.

“I love that idea of a very minimalist ‘set it and forget it’ portfolio,” Benz says.

3. Rebalance your stock holdings

The conventional rule of the thumb is that you should periodically rebalance your portfolio by scaling back on whatever has performed well and putting that money into the asset that hasn’t performed as well.

Currently, the stock market is doing so much better than the overall economy that people are worried about taking their money out of stocks and putting it into bonds. But Benz says that bonds are not supposed to be the high return part of your portfolio. The idea is that when the stocks go down, your bonds hold steady or maybe even go up a littlebit.

“I think that relationship, even if bonds aren’t particularly attractive, will hold up,” Benz adds, “so I say, if you haven’t rebalanced your portfolio in a while hold your nose and buy some bonds.”

Free tools on Morningstar.com

In addition to her weekly column, Benz advises investors to take advantage of the free tools on Morningstar.com such as the market fair value graph under the “Markets” tab. This graph will show you if the market is overvalued or undervalued.

“I frequently look at that just to do a temperature check…sometimes all the stocks in coverage universe get exceedingly cheap and sometimes they look pricey,” Benz says, “That’s one of the signals you might use when deciding to balance out of stock.”